Could the Yuan Supplant the US Dollar?

Many believe that the US dollar and the Chinese yuan could soon be engaged in a fierce battle for top honors in the world of international finance.

However, John Williams, the chairman of the Federal Reserve Bank (FRB) of San Francisco, stated on May 10 that the yuan could not edge out the dollar as the primary global reserve currency. And I am inclined to think that this banker is correct.

The transformation of the yuan into an official reserve currency

Last fall the International Monetary Fund made a very welcome decision for Beijing when it added the yuan to what is called the SDR basket (SDR – Special Drawing Rights, a supranational currency issued by the IMF in limited quantities). This means that the yuan now has the status of an official reserve currency, along with the dollar, euro, British pound sterling, and Japanese yen.

After the financial crisis of 2007-2009, the yuan became competitive with the British pound and Japanese yen, due to the large volume of yuan transactions in the foreign exchange market and its use in international trade and other international payments. However, the yuan is quite different from the other four reserve currencies included in the IMF basket. Primarily this is because the Chinese currency is still not freely convertible. In addition, right on the eve of the IMF’s decision in August 2015, the yuan’s exchange rate slumped significantly enough to indicate instability.

During congresses of the Chinese Communist Party, the government has often reiterated that the yuan must become an international currency. De jure it is already halfway there (halfway because the IMF decision will not actually take effect until October). But there are big questions about the de facto part.

The means by which the yuan is being internationalized

Almost every month reports emerge that China has signed another currency swap agreement (regarding the exchange of national currencies between central banks) with some country or other. By early September 2015 China had 33 currency swap agreements in place. The total value of the limits of these agreements regarding China’s currency amounted to 3.16 trillion yuan.

Another issue tied to the internationalization of the yuan is China’s creation of overseas offshore clearing centers («yuan hubs»). A «yuan hub» is a type of «terminal» through which non-residents have access to the Chinese currency, as well as a variety of financial instruments denominated in yuan. These hubs oversee payments and settlements in yuan with Chinese companies and banks, including clearing services. Leading Chinese banks are appointed to be the institutions that service the «yuan hubs», working through the banks’ branches and offices in other countries.

Twenty «yuan hubs» were already in service or slated to open by early 2016. The largest of these are currently operating in Hong Kong, Singapore, Taiwan, Seoul, London, Frankfurt, Paris, and Luxembourg.

Ambitious projects intended to raise the yuan’s international prestige are being launched in country after country. For example, in mid-2014, local companies in Malaysia issued Chinese-currency bonds worth 4.4 billion yuan. And the events that occurred in October 2015 in London were even more electrifying. The People’s Bank of China (PBoC) offered one-year bonds – denominated in Chinese currency – for sale on the stock exchange of that international financial center. The debt on offer was worth five billion yuan ($787 million). But bids were tendered for six times that amount – for 30 billion yuan (about $4.4 billion). The Industrial and Commercial Bank of China and the British bank HSBC were the primary coordinators of the debt sale. The Chinese banks ABC, Bank of China, Bank of Communications, CCB, and the English bank Standard Chartered were also involved in the deal.

The yuan is not utilized in transactions between third countries

Early last year, the newspaper Financial News, which is owned by the People’s Bank of China, reported that in 2014 cross-border payments in Chinese currency totaled 9.95 trillion yuan ($1.6 trillion). China’s foreign trade that year was worth 26.34 trillion yuan (exports and imports). According to official Chinese data, in 2014 25% of China’s total international trade employed the yuan. The yuan was also pressed into service in some of China’s other cross-border transactions, such as the exchange of investments, financial remittances, the distribution of dividends and other investment income, etc. In other words, the yuan is only playing the part of an international currency for China in its bilateral relations with other countries. First of all – with neighboring Asian countries. Second – with the nations of Latin America. And then third – with European countries (especially those outside the EU). The yuan is still almost never used with some of China’s biggest trading partners. Such as in trade with the US, for example.

The use of the yuan in trade and economic relations between third countries is still quite exotic. According to our estimates, such external transactions with the yuan are equal to one percent (or 2-3% at most) of China’s total cross-border yuan transactions, which is in striking contrast to the role of the dollar: approximately 2/3 of the total supply of dollars circulate outside their country of origin (the US) and are used in transactions between legal entities and private individuals in third countries.

The scope of the transactions in the offshore «yuan hubs» should not be overstated. The vast majority of the yuan found there (what are known as «offshore yuan») are held in bank deposits. According to PBoC, at the end of 2013 there were about 1.5 trillion of these offshore yuan stowed in deposit accounts. But experts claim that that number could grow to 2.8-3.0 trillion yuan by the end of 2015. According to various estimates, from 80 to 90% of all offshore yuan deposits are concentrated in Hong Kong, Taiwan, and Singapore. Some industry insiders call these centers China’s «financial provinces». Other centers where offshore yuan are amassed include London, Frankfurt, and Luxembourg. Now let’s compare offshore yuan deposits with the deposits in Chinese banks. According to PBoC, the latter amount to approximately 100 trillion yuan. The ratio between offshore and onshore yuan deposits is about 1.5-3%. And if one looks only at offshore deposits outside of the «financial provinces» (Hong Kong, Taiwan, and Singapore), then that proportion shrinks to a fraction of 1%. To further illuminate how modestly the yuan in deposit accounts have been internationalized, let’s compare that currency with the US dollar. Deposits of «greenbacks» outside the United States are equal to approximately 30% of the dollar deposits inside the US.

Does Beijing have a long-term currency policy?

Interestingly, one obstacle to the internationalization of the yuan is its trade surplus. China is firmly maintaining and expanding its positive trade balance. In 2014, that was equal to $384 billion, which grew to a record level of $594.5 billion in 2015. With this trade balance, the yuan cannot become a de facto reserve currency. A large quantity of yuan can only emerge if there is a negative trade balance outside of China, which Beijing can use for payments to cover its trade deficit. That’s exactly how the US has been operating for many years. Many economists now acknowledge that the price of making the dollar an international currency has been the de-industrialization of America.

Judging by statements from some Chinese politicians and economists, in order to reach the goal of converting the yuan into an international currency, a combination of the following two methods may be used: a) the trade balance must go from positive to negative, and b) the influx of foreign capital into China must be accelerated. At that point the yuan will secure a favorable exchange rate, China will spend the yuan it pockets on imports, and a cache of Chinese currency will briskly accumulate outside of China.

But even in this scenario the yuan will not become a real international currency or be a universal means of payment. It will be an international currency of limited efficacy. The yuan will circulate between foreign countries and China: traveling out of China into a foreign country to pay for imports and traveling out of a foreign country into China for investment. However, the yuan’s plight as a «constricted» international currency will not last long. Once the cream has been skimmed off the assets of the Chinese economy, non-residents’ interest in the yuan will abate. After spending a bit of time in its global orbit, China’s currency will suddenly go into free fall.

So what’s the takeaway here? If that happens, China will lose sovereignty over its economy, since its assets will be seized by foreign capital. And China will not be able to regain its lost position as a global exporter. There will be no second «Chinese economic miracle», because that was staged from the beginning with the assistance of the West. The West has other plans now, and a strong China plays no part in them. But it is not too late for Beijing to consider the traps that await if it attempts to convert its currency from national to global by imitating the US path.